Full disclosure

The Federal Reserve has flunked a crucial part of its bank stress tests. The watchdog is happy enough saying what might happen to big banks if the economy tanks like in 2008: they could lose up to $462 billion. But it’s shy about revealing the effects of a sharp rise in interest rates. That’s just as real a risk that the Fed should disclose to investors.

The regulator did at least run the numbers this time round. But it didn’t release the results, instead stating in a footnote that it’s considering whether to do so in the future. It’s hard to justify staying silent on findings from a scenario that seems more likely than others. After all, another 2008 crisis does not appear to be lurking around the corner. Leverage is down and capital is up. And it will take years before the U.S. consumer embraces the kind of credit culture that fed Wall Street’s securitization machine at the heart of the crisis.

That’s not to say the published results are irrelevant. But interest-rate risk looks more pertinent – even the Fed, along with other regulators, has warned banks to be mindful of the pain it could bring. But it’s unclear how much bankers are taking such advice to heart given expectations that the central bank will keep rates low for years. And deposits, borrowing costs and hedges could all take a hit from a shock.

That much should be clear from the “adverse scenario” the Fed ran on banks’ balance sheets – the first time it has conducted this Dodd-Frank-mandated test. Here the Fed imagines stagflation: the economy falls into a modest recession while inflation pushes borrowing costs higher. Given the buildup of interest-rate risk in credit markets after years of exceptionally low yields, the results from this scenario would be more interesting and relevant to the safety and soundness of the financial system than the “severely adverse” test released on Thursday.

Earlier this year, the Fed ran its own balance sheet through a number of interest-rate scenarios and published the results. It should do the same with the banks it regulates.

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Context News

On March 7 the Federal Reserve reported that all but one of the largest U.S. banks have enough capital to withstand a severely stressed economic environment. In a scenario where unemployment reaches 12.1 percent, equity prices drop more than 50 percent and home prices fall more than 20 percent, projected losses for the 18 bank holding companies tested would total $462 billion, the Fed found.
Ally Financial, which is now 74 percent owned by taxpayers, was the only bank to fail the test.
The Federal Reserve also tested the banks for an adverse scenario in which inflation pushes the 10-year Treasury yield up to 5.4 percent, corporate borrowing costs to 8 percent and mortgage rates to 7.2 percent by the end of 2015. The central bank did not release the results of this test.
The Fed has said that it will evaluate whether public disclosure will “assist in informing the company and market participants about the condition of the banking organization.”